(Yahoo!Finance) - With a rapidly-growing $4.8 trillion market share, model portfolios are a major part of the investment space. In fact, more than half of advised assets are in model portfolios, and data provider Broadridge Financial Solutions has forecast that models will control more than $10 trillion in assets by 2025.
However, new research has emerged indicating model providers are channeling money into funds that are more expensive and boast lower performance than others. Even though model portfolios are exploding in popularity, it might be time to rethink your investments.
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The Model Portfolio: A Closer Look
Model portfolios, created by asset managers and investment strategists, are third-party investment recommendations composed of stocks, bonds and funds. Given that investment information can be costly to produce, models provide financial advisors with cookie-cutter investment blueprints applicable to a large swath of investor types.
Yet a recent paper by a group of academics argues that model portfolios are plagued by conflicts of interest, with model providers often favoring their own exchange-traded funds (ETFs) with little regard to performance.
Asset managers provide many of the model investment portfolios and may benefit from increased cash flows to their funds. Furthermore, “when model providers include their own funds into recommendations, they get indirectly compensated through asset management fees charged by these affiliated ETFs,” the authors of the new paper state, which might provide incentives to recommend funds with high expense ratios.
For all that, not all model portfolios include affiliated ETFs. Much of the decision-making is based on a manager’s experience and judgment, and although asset managers are required to disclose potential conflicts of interest in their filings, the exact reasoning for including an affiliated ETF in a model may be difficult to determine.
The researchers attempted to compensate for this uncertainty by comparing affiliated and unaffiliated ETFs and found that affiliated ETFs often underperformed in comparison. Even so, recommended ETFs still outperformed non-recommended ETFs by a significant margin.
Why Are Model Portfolios Gaining Popularity?
Among financial advisors these models have grown increasingly popular as a way to outsource investment allocation decisions. This saves time and allows them to focus more on financial planning services and client relationships.
The authors note that “funds and separate accounts may be better aligned with [advisor] clients than the model providers because [advisor] compensation is a direct function of the performance of the selected portfolio.” But the study also found that model-recommended ETFs averaged returns of 0.77% versus -0.47% for non-recommended ETFs, so model portfolios do still appear to offer some benefits.
Indeed, despite the general opacity of the industry, investors themselves are increasingly willing participants in model-directed investments. Fund investors are sensitive to the fee and quality of the funds, but investor demand for model-recommended ETFs seems to be different. According to the research, investors who follow model recommendations exhibit weaker sensitivity to price and fund returns, completely following the recommendations with less attention to details.
What It Means Going Forward
Model portfolios may give financial advisors an opportunity to allocate day-to-day investment management responsibility to an outside strategist, but in the end, your money is still your responsibility. As a large and growing branch of the advised asset industry, model recommendations are not as heavily regulated as the investments they recommend.
Models have fewer barriers to entry and cost less to launch than mutual funds and other vehicles, for example. They do not have to register with the Securities and Exchanges Commission (SEC) or pay a bank a fee to hold custody of assets because model providers do not hold the assets.
At the same time, ETF holdings are regularly disclosed and strategies are published in public filings, but combinations of ETFs operate by different, more flexible rules. Regulations for ETF model portfolios are largely non-compulsory, covered mostly under the SEC’s advisor advertising rules.
Due diligence continues to fall on both the financial advisor and the investor.
The Bottom Line
Recent research indicates that, despite the increasing number of model recommendations, conflicts of interest seem to materially affect the quality of model portfolios.
The reasons why financial advisors offer these models vary, and with an abundance of financial products available, investors may feel more comfortable following strategic recommendations than choosing individual funds. However, investors may benefit from increased scrutiny of their investment choices–especially if you follow a model-recommended portfolio.
Retirement Planning Tips
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By Christine Williams
